Business

What is the Difference: Finance Lease vs Operating Lease?

Companies usually prefer to lease long-term assets rather than buying them. The leasing determination is mainly based on factors like a requirement, better commercial terms, Keeping assets from the balance sheet, or the shortage of funding. In simple words, The lease is basically an agreement of finance in which the asset owner buys the asset and allows the asset’s user to utilize the asset for a restricted time against periodic payments, i.e. lease rentals. The terms and conditions of this process are addressed in the lease deed. Apart from that, these two are the accounting field areas. You can also take Financial Accounting Assignment to help to know more about this topic.

The system of financing and leasing assets may not be as clear as always. And one of the common areas of confusion we face is understanding the contrast between a finance lease and an operating lease. Here in this article, we will explain both type of lease and their comparison.

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What is a Finance Lease?

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A finance lease is considered a lease in which a company is the rightful owner of the asset until the lease’s duration, While the user has operational control across the asset with some share of the financial risks and returns from changes in the valuation of the underlying asset.

A financial lease includes an agreement in which the owner allows the user to use a specific asset for a fixed time, covering the asset’s economic life’s main role with the transferal of risk and rewards known as Finance Lease.

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In a financial agreement, when the lease period ends, the asset’s ownership is passed to the lessee. The rentee has the choice of buying the asset at a nominal rate, i.e. a price less than the asset’s fair market value. In a single contract, the lease returns the full payout, i.e. principal (cost) plus interest on the asset. At the beginning of the lease agreement, the present value of the minimum lease payments (MLP) is more than or equal to the asset leased’s gross fair market value.

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The finance lease is irrevocable in nature i.e. It can be canceled only if the Lessor requires or allows some contingent occurrence to the lessee enter into a lease agreement for the same asset. However, if the loaner cancels the lease arrangement, the lessee will cover any damages suffered by the Lessor.

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What is an Operating Lease?

An arrangement in which the lessee is entitled to use the asset with the lessor consent for a short duration is less than the asset’s economic life without the transfer of title, risk, and reward is referred to as an operating lease. An operating lease is more like a leasing arrangement, and that is why a rental cost in the Profit and Loss Account in the lessee’s books is paid for the rental fees for the use of the asset.

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The asset shall not be sold to the lessee at the conclusion of the operating contract, nor shall the lessee be allowed to buy the asset at a price less than the asset’s fair market value. At the expiry of the leasing agreement, the leased asset is transferred to the Lessor. There is no guarantee that the Lessor can earn the full payment for the asset’s expense and return when the same asset is rented to several customers again and again by the Lessor. In nature, the operating lease is cancellable and so, it can be canceled by any of the parties.

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Important Contrasts Between Capital Lease and Operating Lease

Here we have listed the major differences between a finance lease and operating lease:

1.The lease arrangement under which the cost and benefits are exchanged with the transfer of an asset is known as Finance Lease. The lease arrangement under which the risk and benefits are not exchanged with the asset transfer is known as Operating Lease.
2.A Finance Lease is a kind of credit arrangement in which the financer plays the Lessor’s position. In contrast to the operating contract, which is similar to a lease agreement.
3.The Finance Lease is long-term as it occupies the entire portion of the asset’s life. Unlike, for a shorter time, Operating Contract.
4.Compared to a financial lease, an operating lease is more flexible.
5.In a financial contract, at the conclusion of the lease period, the asset’s ownership is transferred to the lessee by paying a nominal sum equal to the fair market value of the asset. Conversely, there is no such form of option in an operating lease.
6.The lessee bears the risk of obsolescence in the Financing Contract, while the Lessor bears the risk in the Operating Lease.
7.The lessee will incur all costs for repairs and maintenance in the financial lease, but the Lessor in the operational lease will bear the cost of repairs and maintenance.

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Conclusion

These days numerous businesses enter into these lease agreements because the company does not directly bear the cost of financing the asset. Therefore, the finance lease and operating lease are getting popular. One of the best advantages of these lease agreements is that the depreciation and interest charges are tax-deductible in nature, and so they are allowable as a deduction. To know more about these two accounting fields, you can take Accounting and finance assignment help online.

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