Let’s begin by first understanding what a lease is, before delving into the topics of operating and financial lease. A lease can be defined as an implied or formal written agreement to rent out a property. There are two parties involved: a lessor and a lessee. The former leases out the ‘lease asset’ to the latter in exchange for a periodical consideration or lease rentals.
Lease is an excellent source of passive income. For enterprises, it aids in maintaining liquidity. A lot of individuals mistakenly think that a lease is the same as paying rent. Compared to renting, a lease is different.
An individual who signs a lease has the option to purchase the property at the end of the term and is not bound to a short-term contract or a rental agreement, instead, there is a lease agreement involved under a contract of lease.
Typically, there are two types of leases: operating lease and finance lease. Continue reading to find out more about the types of leases, examples, and distinctions.
What is an Operating Lease?
When an asset is leased under an operational lease, the lessor still retains ownership of it (legal ownership). To put it simply, in an operating lease agreement, the right to use assets is granted but not the right to own them. It is used especially when a corporation has to replace its assets or when it needs to use its equipment for an extended period of time.
An operating lease allows the lessee to return the financed equipment to the lessor without incurring any further obligations at the end of the lease term.
As businesses cannot buy the asset under an operating lease contract. It makes sense for many small and medium-sized enterprises to rent these pricey assets because doing so is more cost-effective for them than purchasing them outright.
What is an Example of an Operational Lease?
The finest illustration of an operational lease is when a coworking space aggregator like Stylework rents out workspaces to businesses, sparing them enormous capital costs that they would otherwise have to pay in purchasing office spaces.
The important thing to remember is that office space is a need for organisations. Since purchasing office space would be outrageously costly, the best choice is to lease it via workspace aggregators. The companies would pay the coworking space aggregator rent and record the leased workspace as an asset on their balance sheet because they are likely to require it for a longer period of time.
On a side note, In addition to factory leasing and setup and office spaces, Stylework also offers godowns, and warehouses for lease, all with the bare minimum of legal formalities and for an extended lease term.
People Also Read: Coworking Space – New Paradigm of Work Culture
What Do You Mean by Financing a Lease?
In a finance lease, the asset is given to the lessee as part of a long-term financial arrangement.
In a finance lease, which is a particular kind of commercial lease, the lessee bears practically all of the costs and benefits of owning a fixed asset. Buying assets for the majority of their useful life is common in a finance lease. If a successful “offer to buy” is made for the asset at the end of the lease term, the lessee will then become the owner of the asset. It is also known as the capital lease.
Under a finance lease, when the lease period is up, ownership of the asset is given to the lessee. The asset may be purchased by the lessee at a nominal price, which is a price lower than the asset’s fair market value. The lessee pays back the entire payout, which includes the asset’s principal (cost) and interest, in a single lease.
The finance lease is non-cancelable, meaning that it can only be terminated in the following circumstances: the lessor consents; a contingent event occurs; or the lessee enters into a lease arrangement with the lessor for the same asset. However, any losses sustained by the lessor as a result of the lessee’s cancellation of the lease are the lessee’s responsibility.
What is a Finance Lease Example?
An easy financing lease example would be a production-based company that wants to purchase manufacturing equipment or machinery but can’t afford it so instead opts for a finance lease.
In this way, the business acquires ownership of the asset, can document it for tax purposes and depreciation and can do all of this without having to bear the burden of a sizable one-time expense in a single fiscal year. Instead, they can stabilize their cash flow by paying the asset’s monthly lease rental installments.
Operating lease vs Finance lease – Key Differences
Due to their technical nature, operating leases, and finance leases can sometimes be difficult to distinguish from one another. Here is an attempt to make you understand the difference between a finance lease and an operating lease.
|Basis||Operating Lease||Finance Lease|
|Risks and Rewards||In an operating lease, the risks and rewards are still with the lessor.||The lessor transfers all the risks and rewards in relation to the asset to the lessee.|
|Ownership||The ownership is not transferred. It remains with the lessor.||Transfer of ownership happens at the end of the lease term to the lessee.|
|Bargain purchase option||No such benefit of ‘Bargain purchase option’.||Under finance lease, lessee has a bargain purchase option which means lessee will have the option to buy the leased asset at nominal value i.e. below market value.|
|Lease term||Less than 75% of the leased asset’s anticipated useful life is covered by the lease period.||Lease term substantially covers the economic life of the asset.|
|Nature of contract||Also widely known as ‘Rental agreement/contract.’||Alternatively known as ‘loan agreement or contract’.|
|Maintenance||Since an operating lease merely grants the right to use the asset, the lessee is not responsible for any maintenance, administration, registration, repairs, etc. All maintenance costs are covered entirely by the lessor.||With a financing lease, the lessee would be responsible for looking after and maintaining the asset. He is also responsible for paying all additional running and administrative costs.|
|Risk of obsolescence||Rests with the lessor.||Rests with the lessee|
|Cancellation||It lies on the part of the lessor.||It lies on the part of lessee|
|Tax Deduction||The lease payment is regarded as an expense because an operational lease is similar to renting. No claim for depreciation is allowed.||As a financial lease is regarded as a loan, the lessee may deduct interest and depreciation.|
|Purchasing option||Under an operational lease, the lessee is not given the choice to purchase the asset at any point during the term of the lease.||In a financial lease, the lessee is given the option to acquire the asset after all the lease payments.|
|Accounting effect||In most cases, an operating lease is regarded as a rental. As a result, the asset is not listed on the balance sheet and the lease payments are considered operating expenses.||In most cases, a financial lease is regarded as a loan. Here, the lessee takes into account asset ownership, hence the asset is recorded on the balance sheet.|
|Term of Contract||It is a short-term contract.||It is generally a long-term contract.|
Which is Better, Finance or Operating Lease?
The answer to this query is ‘Relative’ and frequently relies on the specific circumstance/situation in which you find yourself.
An operating lease agreement streamlines the end user’s administrative tasks and enables them to simply return the asset at the end while making a single, easy monthly payment. This is helpful for organisations for whom it is not practical to buy the asset outright.
An operating lease is your best bet if you want to use assets but don’t want to show them in your accounting records.
On the other hand, a finance lease has more administrative obligations and, depending on the asset’s type, may occasionally come with an increased risk of resale for the lessee.
When a lessee needs an asset but lacks the cash to buy it right away, he can utilise a financing lease to buy the asset by paying monthly payments in instalments, much like your EMIs.
People Also Read: What Challenges Do Entrepreneurs Face while Running a Business?
The Bottom Line
Now that you are aware of the distinction between an operating lease and a finance lease, you won’t mistake the two.
As the corporation does not directly incur the cost of financing the asset, many business concerns today participate in these leasing agreements. As a result, operating leases and finance leases are growing in popularity.
The fact that the depreciation and interest costs can be claimed as a tax deduction and may therefore be availed as the deduction is one of the main benefits of these lease arrangements. Similar to how they are tax deductible for operating leases, leasing rentals are likewise permitted as a deduction.
Understanding a financial lease and an operating lease is crucial. Knowing these will enable you to choose the one that is best for your company in the particular scenario.