What are the Differences Between Finance and Operating Leases?
Paul RyanIntroduction
Leasing is a popular financing option for businesses to acquire equipment or property without having to purchase them upfront. There are two types of leases:finance leaseandoperating lease. In this article, we will discuss the differences between finance and operating leases.
Definition of Finance Lease
A finance lease is a long-termlease agreementwherein the lessee (the business) assumes most of the risks and rewards of ownership. Finance leases generally have a duration of more than 75% of the asset's useful life, and at the end of the lease term, the lessee usually has the option to purchase the asset at a predetermined price.
Definition of Operating Lease
An operating lease is a short-term lease agreement wherein the lessor (theleasing company) retains most of the risks and rewards of ownership. Operating leases generally have a duration of less than 75% of the asset's useful life, and at the end of the lease term, the lessee can return the asset to the lessor or renew the lease.
Accounting Treatment
One of the main differences between finance and operating leases is how they are accounted for. Finance leases are treated as assets and liabilities on the lessee's balance sheet. The leased asset is recorded as a fixed asset, and the lease obligation is recorded as a liability. On the other hand, operating leases are not recorded as assets and liabilities on the lessee's balance sheet. Instead, the lease payments are recorded as expenses on the income statement.
Ownership
Since finance leases are long-term agreements, the lessee assumes most of the risks and rewards of ownership. At the end of the lease term, the lessee usually has the option to purchase the asset at a predetermined price. In contrast, operating leases are short-term agreements, and the lessor retains most of the risks and rewards of ownership. At the end of the lease term, the lessee can return the asset to the lessor or renew the lease.
Tax Implications
Finance leases and operating leases have different tax implications. For finance leases, the lessee can claim depreciation and interest expense deductions on the leased asset, which reduces their taxable income. On the other hand, for operating leases, the lessee can claim the lease payments as tax-deductible expenses.
Investment Advice
When deciding between finance and operating leases, it is essential to consider your business's needs and financial situation. Finance leases are suitable for businesses that want to acquire assets for the long term and are financially stable enough to assume most of the risks and rewards of ownership. Operating leases are suitable for businesses that need assets for the short term and want to avoid tying up too much capital in assets. It is also important to consult with a financial advisor or accountant to determine which type of lease is best for your business.
Conclusion
In summary, finance and operating leases differ in terms of duration, accounting treatment, ownership, and tax implications. When deciding between the two types of leases, businesses should consider their needs and financial situation and consult with a financial advisor or accountant. Leasing can be a cost-effective way for businesses to acquire assets, but it is important to choose the right type of lease to maximize its benefits.
Article review