Leases are also generally categorized under operating leases and financing (or capital) leases with different accounting and financial effects. An operating lease is an agreement for rental of assets of short term wherein the lessee does not retain ownership and so is best for assets that will have a finite useful life. Conversely, a financing lease shifts most of the ownership rights and risks to the lessee, viewing the asset as a long-term investment. It is important for businesses to understand the differences between these types of leases in order to make sound financial decisions.
In this blog, we will discuss the major characteristics, benefits, and accounting treatments of operating and financing leases.
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 mainly in terms of accounting treatment and their impact on ownership and financial reporting. Operating leases are generally applied for short-term contracts where the asset is returned to the lessor at the expiration of the lease term; lease payments are charged as rental expense on the income statement and not reflected on the balance sheet. In essence, operating leases provide flexibility and are applied to assets not core to the business, whereas financing leases are applied to long-term assets that are core to operations.
