What Are Operating and Financing Leases?

The term lease is defined as a contact between the owner of an asset that is called the lessor, or the user of the assets that is called the lessee. 

The lessor of the contract gives the right to the lessee to use the assets or equipment for an agreed period of time. The lessee pays rental consideration to the lessor for the use of assets or equipment.

The lease is treated as the most suitable method for financing most investments such as office equipment, machinery, aircraft, high-value cars, software, mining equipment and alternative energy.

In simple words, we can say the lease is a method of acquiring the right to use equipment or assets for consideration.

Definition

A lease can be defined as an agreement whereby the lessor conveys to the lessee, in return for a payment or a series of payments, the right to use an asset for an agreed period of time.

Financing Lease:

The financial lease is also known as the capital lease. The assets held under financing leases are capitalized in the lessees’ financial statements at the lease’s commencement. Under the financial lease, assets are held for a long period. The time duration is equal to the economic life of an asset.

A finance lease is similar to a hire-buy arrangement or closed-end leasing in that the lessee typically becomes the owner of the asset at the end of the lease but has distinct accounting and tax treatment. Tax incentives may exist for lessees who lease an asset rather than purchase it, which may be a factor in their decision to get a financing lease.

Accounting Treatment of Finance Lease as per IFRS

IAS 17, “Leases,” is the regulating standard in the more than 100 nations that regulate accounting using International Financial Reporting Standards. However, it is being phased out and will be replaced by IFRS 16, “Leases,” beginning in 2019. While IAS 17 is analogous to FAS 13 in the United States, IAS 17 does not require “bright line” tests on the lease duration and present value of rentals (specifying an exact percentage as a limit). Rather than that, IAS 17 includes the following five examinations. If any of the following conditions are met, the lease is classified as a financing lease:

• The lessee acquires ownership of the asset at the end of the lease term;
• the lease contains a bargain purchase option to purchase the equipment for less than fair market value;
• the lease term is for the majority of the asset’s economic life, even if the title is not transferred; and at the lease’s inception,
• the present value of the minimum lease payments is at least substantially equal to the asset’s economic life.
• The leased assets are specialised, allowing them to be used exclusively by the lessee without significant modification.

Operating Lease:

Leases for operating purposes are not capitalised. If an operating lease does not transmit virtually all of the risks and rewards associated with ownership, it is a lease. According to AS-19 and IAS-17, an operating lease is any lease that is not a finance lease. An operating lease is for a short amount of time in comparison to the asset’s or equipment’s useful life.

In an operating lease, the lessor is responsible for all kinds of maintenance, insurance, and all other expenses related to the leased amount.

The difference between Financing and operating leases

Difference	Financing Lease	Operating Lease
Duration	Financing leases for the whole useful  life of assets	Operating lease on a short-term basis
Revocation	The lease contracts cannot be revoked under a financing lease.	The lease contracts are revocable under the operating lease.
Obsolescence risk	Under the financing lease, the lease has to bear the risk of obsolescence.	Under the operating lease, the lessor has to bear the risk of obsolescence.
An option of purchase	At the end of the contract, the lessee has the option to buy the assets.	No such option is available for the lessee in operating- lease contracts.

Conclusion

Operating leases and financing leases differ primarily in their accounting treatment and implications for ownership and financial reporting. Operating leases are typically used for shorter-term arrangements where the asset is returned to the lessor at the end of the lease period; lease payments are recorded as rental expenses on the income statement and do not appear on the balance sheet. In contrast, financing leases, also known as capital leases, are designed for longer-term use, where the lessee assumes most of the risks and rewards of ownership. These leases require the asset and corresponding liability to be recorded on the balance sheet, impacting financial ratios and requiring the lessee to account for depreciation and interest expense. Essentially, operating leases offer flexibility and are often used for assets not central to the business, while financing leases are used for long-term assets integral to operations.