Financial Lease vs Operating Lease: Know the Difference

Understand the differences between financial and operating leases. Learn their features, advantages, and accounting treatments to choose the right option for your needs.

Leasing is a popular and practical way to have access to assets without the upfront cost of purchasing them. Many businesses often rely on leasing offices or workspaces. Two of the most common types of leases are financial leases and operating leases. Though both types would allow you to use assets, they differ in terms of ownership, responsibilities, and lease duration. Let’s understand more about financial lease vs operating lease with the following read. Here, we will explain the major differences between a financial lease and an operating lease in detail.

What is a financial lease?

It is a long-term agreement wherein the lessee takes on significant responsibilities for the asset and enjoys benefits almost similar to ownership. This lease type is often used for assets that are important for business operations and have a long useful life. Here are some of the major features of a financial lease:

• In a financial lease, the lessee does not own the asset during the lease period but often has the option to purchase it at the end of the term.
• It is for long-term use as the lease period usually matches most of the asset’s useful life.
• The lessee is responsible for all costs such as repairs, insurance, and maintenance.
• It is perfect for businesses that rely on specific assets for their core operations like heavy machinery.

What is an operating lease?

On the contrary, an operating lease is a short-term arrangement that allows the lessee to use the asset for a specific period without ownership. This is perfect for temporary needs. Here are some key features of an operating lease:

• The lessor retains ownership and the asset is returned to them once the lease period is over.
• The lease period is often much shorter than the asset's total lifespan.
• The lessor usually handles maintenance, repairs, and insurance.
• It is perfect for businesses or individuals who need flexibility such as renting workspaces or equipment for a specific project.

Difference between financial lease and operating lease

Feature

Financial Lease

Operating Lease

Ownership

Can be transferred to the lessee at the end of the lease.

Remains with the lessor.

Lease period

Long-term

Short-term

Responsibility

The lessee is responsible for maintenance and repairs

The lessor is responsible for maintenance and repairs

Purpose

Best for long-term use of assets

Perfect for temporary use

To better simplify financial and operating lease differences, read on to learn more about their advantages.

Advantages of a Financial Lease

• It provides a reliable way to use essential assets for most of their lifespan.
• There are fixed costs and hence, these regular lease payments make budgeting predictable and simple.
• As mentioned earlier, the lessee may purchase the asset at the end of the lease term, thereby, allowing for ownership.

Advantages of an Operating Lease

• It has flexibility as operating leases allow you to use an asset for a short time without the commitment of ownership.
• It is associated with low costs as the lessor is responsible for repairs and maintenance.
• You have no long-term commitment with an operating lease as it is mostly for businesses or projects with temporary needs.
• With an operating lease, you can easily switch to newer models or technologies when the lease ends.

Financial and operating lease- Differences in accounting

The treatment of financial and operating leases in accounting varies. In a financial lease, the asset is recorded as an asset on the lessee’s balance sheet. The lessee also records a liability equal to the lease obligation. Here, lease payments are split into interest expenses and principal repayment, just like a loan.

On the other hand, in an operating lease, the lease payments are recorded as an expense on the income statement. There is no need to show the asset or liability on the balance sheet.

When to choose a financial lease

A financial lease is a good option if:

• You need the asset for a long time and want permanent ownership.
• The asset is important to your operations and will not become useless soon.
• You are prepared to handle all costs including maintenance and insurance.

When to choose an operating lease

You can choose an operating lease if:

• You need the asset temporarily or for a short-term project.
• You want to avoid the responsibilities of ownership such as maintenance and insurance.
• You are looking for flexibility so that you may upgrade or switch to a newer model later on.

Things to consider before leasing

Before you decide between a financial lease and an operating lease, here are some of the factors you must consider:

• Check for how long you would need the asset. If it is for the majority of its useful life, a financial lease is better. If not and for shorter durations, you can consider an operating lease.
• Budget is of great importance and hence, make sure you assess your financial capability to handle ownership costs, whether it is insurance or repairs.
• Consider your ownership goals too. If you are looking to own the asset eventually, a financial lease is the right choice.
• Do not ignore your flexibility needs as operating leases are more flexible and allow you for easy upgrades.

Final Word

Leasing helps you use things without buying them. A financial lease is good for long-term use and ownership later, while an operating lease is better for short-term needs. Hence, choose what works best for you!

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