Understanding the differences between operating and finance leases is critical to commercial success.
Operating leases and finance leases are two of the most common types of contracts that companies use today. Understanding the differences between them is critical to commercial success, and anyone running a company should carefully weigh their options when considering contract agreements.
There are several different ways to distinguish between operating leases and finance leases, and this blog will not only define each lease type but outline the key differentiators between the two.
A finance lease (a capital lease) is a commercial leasing arrangement where a finance company legally owns an asset, and the user rents it for an agreed-upon period. In this contract, the leasing company, typically the finance company, is referred to as the lessor, while the asset user is called the lessee.
Upon entering this agreement, the lessee gains operational control over the asset and assumes all associated risks and benefits of ownership. From an accounting perspective, the lease grants the lessee the economic attributes of owning the asset. The lessee records the asset as a fixed asset in their financial records, while the interest portion of the lease payment will be logged as an expense.
To meet the criteria for classification as a finance lease under US GAAP, the lease contract must satisfy at least one of the following conditions:
With the IFRS, a lease is considered a finance lease if it meets all of the following criteria:
A finance lease essentially functions as a business rental agreement, involving the following steps:
Regarding accounting, a finance lease significantly impacts a company’s financial statements. These leases are treated as ownership rather than rentals, affecting interest and depreciation expenses, assets, and liabilities. Due to capitalization, a company’s balance sheet shows increased assets and liabilities, while working capital remains unchanged.
The debt-to-equity ratio, however, rises. Expenses related to a finance lease are divided into interest expenses and principal value, akin to a bond or loan. Some payments are reported under operating cash flow, while others fall under financing cash flow, leading to an increase in operating cash flow for companies involved in finance leases.
Finance leases are customized based on the specific needs of both lessor and lessee. Despite variations, most finance leases typically include:
• Names of both parties, designating as lessor and lessee
• The asset being leased
• Total asset price
• Economic life of the asset
• Interest rate
• Principal and interest payment schedule
• Associated penalties and fees
This lease document can be intricate, and it’s advisable to consult a business or financial services lawyer to ensure the agreement is accurately drafted with all essential information.
Finance leases are employed across various industries, particularly when a company requires expensive equipment but wants to preserve cash flow and avoid a large upfront payment. Some examples of assets leased through finance arrangements include: land, plant equipment, heavy machinery, ships, aircraft, buildings, and patents.
An operating lease is a leasing arrangement in which the lessor permits the lessee to utilize an asset for a brief period in exchange for periodic payments, without transferring ownership rights of the asset.
From an accounting standpoint, leases are categorized as operating under ASC 842 if none of the five criteria for finance leases are met. In business, operating leases enable lessees to treat the leased assets as regular fixed assets while conducting their operations. However, this is only for a limited period, as the assets are ultimately returned to the lessor with some remaining useful life. The lessee essentially rents the asset to facilitate the normal operations of their business.
Operating leases are lease agreements where the terms do not resemble a purchase of the underlying asset. For instance, there is no transfer of ownership at the end of the lease, and the leased asset may be used by someone else after the lease term concludes. If none of the five criteria used to classify a lease apply, it is considered an operating lease.
These leases are employed for the temporary rental of assets and encompass conventional rental relationships. Previously, before the implementation of the new lease accounting standards, these leases were expensed outright, and neither the leased asset nor the associated liabilities were reflected on the balance sheet. Now, irrespective of whether a lease is operating or finance, both an asset and a liability must be recorded on the financial statements.
An operating lease is recognized under ASC 842 if it does not meet any of the following five criteria for finance leases:
In an operating lease arrangement, the lessor allows the lessee to use an asset for a limited duration in exchange for periodic payments. However, ownership rights of the asset remain with the lessor, and there is no transfer of ownership at the end of the lease term. The lessee treats the leased asset as a regular fixed asset, incorporating it into their business operations. Ultimately, the asset is returned to the lessor, typically with some useful life remaining.
An operating lease typically includes the following key elements:
Operating leases are commonly used for assets that have a limited lifespan or that are specialized and not expected to have alternative uses. Examples of assets frequently leased through operating agreements include: office space, vehicles, equipment, technology, and retail space.
Under IFRS accounting standards, if the risks and rewards are fully transferred, it is a finance or capital lease. Sometimes this can be hard to determine, so the IASB outlines it as if one of the following criteria apply:
Before the introduction of IFRS 16, numerous operating leases were recorded off the balance sheet. However, this changed, and all leases must now be treated in the way that finance leases are treated under IAS 17 except for those that meet the practical expedient for low value/short-term leases. Lessors are required to show a lease receivable and a future flow in income for each lease. To get a more thorough understanding, read our blog on the changes to accounting for operating leases under IFRS 16.
Whether you’re working with operating or finance leases, the administrative burden can overwhelm companies that do not have the right software. Investing in purpose-built property management software will be essential to effectively managing operating and finance leases and enabling your company to remain compliant.
Understanding the differences between operating and finance leases is essential. Every company’s demands are different, and fully understanding the compliance demands and risks can help you decide which option works best for you, whether you’re the lessee or lessor.
