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What are your options when you need an asset for your business, but don’t immediately have the funds to make a purchase? This is where leasing comes in. Taking out a lease on a vehicle or vital piece of equipment gives you access to the asset you need, without paying for it upfront. There are two types of leases to be aware of for accounting purposes – finance and operating. So, what is a finance lease, and how does it differ from an operating lease? We’ll discuss the ins and outs below.
What is a finance lease?
Also called a capital lease, a finance lease allows the customer (or lessee) to hire an asset from the lessor and use it for most of the asset’s lifespan. Under this type of agreement, the customer is responsible for maintenance costs and assumes the risks of ownership such as value fluctuations. With this ownership comes the need to record the asset on the balance sheet.
Upon entering a finance lease agreement, there’s a primary rental period with monthly payments that add up to the asset’s full cost, plus interest. When the primary rental period ends, the asset is close to the end of its useful lifespan. At this point, the customer can choose from the following options:
They can enter a secondary lease period and continue to use the asset
They can sell the asset and retain a share of income
They can return the asset
A finance lease is commonly used in auto financing, for example. You can hire a car for your business, assuming all maintenance and risk for the duration of the lease term. At the end of the term, you can either make a residual payment and retain ownership of the vehicle or hand it back to the lessor.
What is an operating lease?
Now that we’ve looked at how a finance or capital lease works, what about an operating lease? This is also a contract that allows the customer to hire an asset for personal or business use. However, an operating lease tends to involve shorter loan terms and the customer does not take on any of the responsibilities of ownership, as they would with a finance lease.
Instead, the customer simply uses the asset and then returns it at the end of the loan term. Because there is no ownership responsibility at any point of the term, the asset doesn’t need to be recorded on the balance sheet.
Finance lease vs. operating lease
As you can see from the definitions above, there are several key differences between a finance lease vs. operating lease.
A finance lease:
Usually needs to be recorded on the balance sheet
Ownership transfers to the lessee
As an owner, the lessee might be able to benefit from tax deductions like depreciation
The customer has the option to purchase the asset at the end of the term
The lease term is longer
Operating and maintenance costs are responsibility of the customer
An operating lease:
Does not need to be recorded in company accounts
The lessee never owns the asset at any point
The lease term is shorter
The customer returns the asset at the end of the lease period
Operating costs are included as part of monthly repayments
When looking at a finance lease vs. operating lease, the main differences to keep in mind boil down to ownership and how the asset is treated for accounting purposes. An operating lease involves less risk, but there may be tax benefits to a capital lease.
Which lease should you choose?
There are benefits to both types of leasing options, so which is right for you? Ultimately this will depend on how you plan to use the asset and your financial circumstances. If you plan to use the asset until the end of its natural lifespan, you might want to opt for a capital lease. On the other hand, if you only need it for the short term, an operating lease keeps things simple. It involves less paperwork and doesn’t need to be accounted for on the balance sheet.
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